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There are 100 million young people in the Middle East and North Africa. They are a force for change in a region at a crossroads. This blog is focused on ideas for tapping into this immense potential and meeting the aspirations for jobs, justice and dignity.

The Path to more Jobs in the Arab World starts with a dynamic private sector

This blog is part of a weekly series that we hope will provide some food for thought on the critical questions outlined in the forthcoming MENA Flagship Report on Jobs.

An analysis of the quality of growth, and more specifically of the dynamics of the private sector is necessary to understand a region’s underperformance in job creation. While many countries in the Middle East and North Africa (MENA) region had periods of solid growth over the past decade, they all underperformed in job creation. This is because the quality of growth matters as much as the quantity.

One key revelation from this kind of analysis is that the private sector in MENA displays very little dynamism. That is to say, it has one of the lowest numbers of newly registered firms per working-age population in the world (Figure 1), some of the world’s oldest firms, and the highest average age of CEOs. This suggests that the MENA private sector has long been dominated by a limited number of older firms, with newer firms and younger workers struggling to gain access. What is more, recent evidence from firm censuses in Morocco and Tunisia show that even when firms enter the market, they stay small and do not grow.

Other regions of the world have very different results. A comparison of the trajectories of two representative firms in Jordan and Brazil show that while firms start out larger in Jordan, they grow more slowly over time. Over a 10-year period, a firm in Brazil becomes about twice as large as the one in Jordan.

In sum, the vital process of “creative destruction” – the regular entry of new and innovative firms and the exit of older, unproductive ones – that animates a dynamic private sector, has gotten stuck in MENA countries. In fast-growing East Asian or Eastern European economies, creative destruction underpinned technological upgrading over past decades.

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The lack of economic dynamism in MENA countries comes at a significant cost in terms of employment, in particular for skilled labor. It constrains the entry of new firms as well as the growth opportunities of young incumbent firms, which are the engine of job creation in other regions. The evolution of the private sector toward higher value-added activities is also stalled by the lack of dynamism. This limits the scope for product and process innovations, such as the adoption of new technologies and production methods. This has significant consequences for job creation, as this sort of innovation has been identified as a critical source of highly skilled and high-value-added jobs for the educated youth in MENA.

So what explains the lack of economic dynamism and job creation in MENA?

A lot of it has to do with policies and the way they are implemented. Energy subsidies have naturally encouraged energy-intensive industries. The result has been a region with more capital-intensive economies than others at a comparable stage of development. An artificially lower price for fuel depresses the demand for labor, as it makes investing in and operating machines more financially attractive than hiring workers. Fuel subsidies have been shown to disproportionately benefit older publicly owned firms, which are likely to use outdated technologies. Thus, fuel subsidies also suppress incentives to innovate.

The rules governing the business environment have also had an effect. Burdensome business regulations are often used to protect a limited number of privileged, politically connected firms, rather than to catalyze creative destruction. Despite reform gaps in specific policy areas, the legal business environment only partially explains the lack of economic dynamism and creative destruction in Tunisia, Jordan, Morocco, Egypt, or Lebanon, relative to fast-growing East Asian or Eastern European countries.

Instead, the analysis shows that what distinguishes the MENA region is more how the rules are enforced. Inconsistent and uneven policy implementation and restricted access to the things firms need to launch and prosper (i.e. credit or land) create an unequal de facto business environment (in the same industry). The lack of a level playing field and the uncertainty surrounding policy implementation make investors hesitate. This ends up hindering the kind of higher value-added investments that would bring technological upgrading and ultimately, the process of creative destruction. The MENA region has a number of opportunities for addressing the urgency of job creation.

Reforms improving policy implementation should focus on four complementary areas.

First, even though it is a controversial issue, removing costly energy subsidies is likely to pay a triple dividend in terms of job creation. It will reduce the relative cost of labor and immediately incentivize investments in more energy efficient production. By removing the burden of subsidies from the national budget, it would also lower labor taxes, further reducing the (relative) cost of labor. To ensure sustainability and political support for reform, it will be important to adequately compensate those who are most drastically affected. This will be feasible, since removing energy subsidies would free up public resources to establish well-targeted social safety net mechanisms for low income consumers. It would also subsidize the technical assistance and credit, which would assist firms to successfully transform towards more energy efficient technologies. Many countries around the world have successfully used this approach to remove energy subsidies.

Second, institutional reforms that aim to make those responsible for enforcing the rules more accountable would help reduce corruption and create a more level playing field.This could be achieved by making the management of the business environment more publicly accessible and transparent. Transferring responsibilities and decision-making to the lower tiers of public administration would empower those held accountable to a broader base, rather to a single minister or high-ranking official. The quality and skills of public administrations could be enhanced by basing recruitment and promotion schemes on merit or commitment to a development strategy than on regional and sectarian considerations. To ensure the public sector is also focused on fostering dynamism, strategic incentives for public agencies that reward efforts to increase private sector growth could be introduced with a performance tool that assesses the public sector’s unwarranted involvement in the private sector. Moreover, empowering independent anti-trust agencies is essential to bolster competition. A recent assessment of these institutions in MENA highlighted that they all continue to lack full autonomy in the de facto exercise of their function. For example, several agencies lack clear legislation spelling out the process by which staff are appointed, which is a crucial step to ensure impartial hiring. In addition, in all countries, ministers who are in charge of state-owned industries also tend to be the ultimate arbiters of competition cases, leading to conflict of interests. For the sake of a level playing field, this should be changed.

Third, reforms are needed in the financial sector to encourage more lending, especially to small enterprises.Currently, entrepreneurs face a daunting landscape, with little access to credit, and a high price for the capital that is available. The limited development of the financial sector reflects a paucity of legislation, which may be the product of insufficient interest among incumbent institutions to widen access to credit for the population at large. Reforms that foster greater bank competition would induce a fall in prices, make services more accessible for consumers, and encourage lenders to seek new markets. Policies that strengthen financial infrastructure and increase bank competition could include the extension of credit bureaus to cater to small and medium sized enterprises, an overhaul of the current collateral regimes to increase protection of creditor rights and the establishment of an authority tasked with monitoring bank competition to discourage anticompetitive behavior.

The fourth and final area of focus would be the active creation of innovation and entrepreneurship.A fundamental task here would be the promotion of opportunities for the exchange of ideas and technology. This could be achieved by establishing forums that bring together firms and innovators, and by building up infrastructure and regulations for cross border trade. Not only would this guarantee the internal diffusion of knowledge necessary for innovation, it would set up opportunities for the transfer of methods and technology from foreign trade partners. An economy open to trade and bristling with new ideas makes for an attractive investment climate which will be a magnet for export-orientated Foreign Direct Investment (FDI). This can be another important vehicle of knowledge transfer, to the extent that linkages with the local economy can be established. Reforms in this area would also have to include the higher education system, to restore universities to their rightful place as the source of new ideas, and the skills to achieve them. In the same way that firms and innovators need to be brought together, a closer relationship between the private sector and universities should be fostered. This would guarantee that students emerge with the right skills needed in a dynamic and competitive economy. An improvement in the investment climate would in turn lead more young people to the private sector, drawn by the opportunities, especially for the highly educated, that increased competition creates. In the short term, the current shortage of relevant skills could be overcome with specific programs. Only a small number of existing active labor market programs in MENA focus on entrepreneurship promotion, and about a half of the programs are concentrated in Egypt. In addition, only two of them have been rigorously evaluated for their effectiveness. Training programs should be expanded, and they should be regularly assessed to ensure they are teaching the right skills, and successfully meeting both the needs of young people and the private sector.

The path to more and better jobs in MENA starts with a dynamic private sector. The previous pattern of growth without increased employment is clearly no longer sustainable. There are millions of young people eager to apply their talents and skills. They merely lack the opportunities provided by a truly competitive private sector.---This blog is part of a weekly series that we hope will provide some food for thought on the critical questions outlined in the forthcoming MENA Flagship Report on Jobs. The common thread and objective of these blogs are to spur a conversation on “what to tell your Finance Minister.” This was in preparation for the World Bank Annual Meetings in October 2012, where the report's main messages and the results of the live chat were presented to MENA policy makers.